As a trader or an investor, it is essential to understand how options work, and the difference between buy to open vs buy to close. When it comes to options there are different ways to trade them. You can either buy options, where you risk your initial investment with the goal of seeing a price appreciation on the contract, or you can sell options.
This way you will be receiving a premium, but the risk level tends to be higher due to the possibility of the option being exercised. When this happens they are liable and must sell the underlying asset if they sold a call to open. Or buy the underlying asset, if they sold a put to open. Therefore they are obligated to settle the option if the buyer exercises it.
How you can trade options
There are 4 ways in which options can be traded:
- Buy to close
- Buy to open
- Sell to close
- Sell to open
Within each of these different ways, there are also puts and calls. So in theory there are a total of 8 ways in which you can trade options to put it simply.
- Buying put to open
- Buying call to open
- Selling put to open
- Selling call to open
- Buying put to close
- Buying call to close
- Selling put to close
- Selling call to close
Each one may be used in different scenarios and depending on the specific strategy that you want to employ. It is important to consider that when you buy an option you always have the right of selling, which ends up canceling out a position. In the same way, when you sell an option you can always buy it back.
When you sell an option you are obligated to deliver the underlying asset if the option is exercised. For that reason, you can buy back the same contract, which in essence eliminates your exposure to the trade. Let’s assess some of the key differences between buy to open vs buy to close, and how options are created.
How are options contracts created?
An options contract is an agreement between two parties, that gives the buyer the right but not the obligation of buying or selling the underlying asset for a predetermined price (strike price), and during a certain time frame (expiration).
Financial markets connect both buyers and sellers. An options contract is created when someone sells to open, and someone buys to open. This is how options are created.
Although options contracts are not removed from circulation, there are ways in which investors are able to cancel them out. An investor that sells an options contract might buy the same contract back. This way the option he sold might be exercised, but he can then exercise the same option he bought. Selling an option is usually described as writing an option.
If an investor decides to sell to open a put, that gives the buyer the right to sell the underlying asset for a certain price (strike price) and within a certain time frame (expiration date). The seller is obligated to buy the underlying asset at the agreed price if the option is exercised.
If an investor chooses to sell to open a call, then the buyer will have the right to buy the underlying asset at the strike price, and until the expiration date. Therefore, if the option is exercised the investor that sold the call option will be forced to buy the underlying asset at the agreed price.
Buy to open vs buy to close
Buy to open
This is one of the most common ways to trade options. When we compare buy to open, there are far more retail investors that follow a buy to open vs buy to close. When you buy to open, you are essentially buying an options contract, whether it is a put or a call. You may exercise your contract until the maturity date, or sell it to another investor or trader.
When it comes to buy to open, you are paying a premium for the right of exercising the contract, at a predetermined strike price, and within the expiration date. It can also be used as a speculative trade if you think the price will move in a certain direction.
However, in order for an investor or trader to buy to open, they require another trader or investor with an opposite view that sells to open. This means that a new options contract is created, as one investor sells it and another acquires it. The investor selling the contract (sell to open) earns a premium associated with the contract. If the contract expires out of the money then the investor is able to keep his premium.
Unless an investor waits for the expiration of the options contract he bought, he will be able to sell to close. In essence, this means that to end the trade an investor or trader will sell the contract that he previously bought unless he holds until maturity.
Buy to close
When we compare buy to open vs buy to close, we see that institutional investors and more sophisticated traders tend to use this far more often than retail investors. The reason is that the complexity of such a trade is much higher, and so is the risk exposure.
A buy to close is dependent on a previous sell to open. This means that an investor sells an options contract, whether it is a put or a call, and to end the trade he will buy the same contract.
One of the most significant differences between buy to open vs buy to close is the risk level associated with these different trading strategies. When an investor buy to open, the only risk he is facing is the cost of the option.
However, an investor selling options could risk a lot more. If the option moves towards the strike price, this could push the options contract holder to exercise it. Meaning that the investor will either have to forcefully buy the underlying asset if his trade was a sell to open put. Or sell the underlying asset if his trade was a sell to open call.
Buy to open vs buy to close call example
Let’s consider a situation where investor A is selling a call, and the strike price is $100. Investor B buys the call option, and therefore, he can buy the underlying asset for $100 until the expiration. In order to close the trade, investor A will have to buy the same contract back.
This gives him the right to sell the underlying asset to investor B he exercises his call. However, because he now holds the same contract he may exercise the call he bought and deliver the underlying asset to investor B.
Buy to open vs buy to close put example
When it comes to puts, it is a slightly different situation but the mechanics are the same. So, investor A sells a put to investor B. Investor A is therefore obligated to buy the underlying asset at the agreed price, if the option is exercised.
In order to close his trade, he might buy the same put he previously sold. This means that if the option he sold to investor B is exercised, he is forced to buy the underlying asset, but he now also holds a contract that allows him to sell the same underlying asset for the same price.
Why do investors or traders sell options?
The reality is that most options contracts expire worthlessly. This means that it is much more profitable in theory to sell options than to actually buy them. However, it should be considered that in the meantime price fluctuations may create significant returns for investors or traders holding options contracts.
Although this is seen by some financial market outsiders as pure speculation there is much more to it. In fact, investors selling options create liquidity in a market that is known for its wide bid-ask spreads. Additionally, investors are able to buy options contracts thanks to those selling, and this is how options contracts are created.
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